To entrepreneurs preparing a capital increase
At some point in time, a potential evolution of your venture is to look for external funding in order to grow. You might be an entrepreneur with a successful business that you would like to scale, or you might consider the launch of a new product line, etc. You might as well be a start-up founder or even own some real estate assets with potential developments. There are numerous circumstances where raising funds makes sense: it enables to grasp opportunities that would not have been possible due to financial and/or timing constraints.
It is to be noted that capital increases also may occur in less positive circumstances: to rebalance equity at bank request, to incorporate current accounts, …
Hence, when you realise an external capital increase may be in the box, you have to start planning. In this blog article, I will share you some – I hope – useful advice.
To start with a positive note, the fiscal developments in Belgium are rendering investments in young companies (except real estate) more attractive for external investors (natural persons) through the tax shelter for start-ups. While this is only a positive measure for the critical development stage of young companies, it has the merit of existing. We often encounter investors which are looking for this type of investments benefitting from a tax discount, even if the tax cut only represents a fraction of the contemplated transaction.
So, what do you need to think at when planning for a capital increase?
Tip 1: Clean the house
When preparing for a capital increase, you are preparing to welcome a new investor in your closed circle. You will have to clean the house in order to be able to convince investors and build trust. First and foremost, you should have a well-designed shareholders’ pact which will regulate all potential conflicts between shareholders. You should not hesitate to request the support of a corporate law specialist in drafting such an important documentation. Second, you should sort out all issues between associates and/or founders if any. It’s in human nature to avoid tackling a conflict and let the situation deteriorate even further. From an accounting perspective, a clear line should be drawn between corporate assets and some items used privately. Cleaning the shareholders’ current accounts (shareholders’ advances) is also a wise decision. From a pure company governance perspective, keeping well documented minutes of all decision-making bodies is, besides a legal duty, a proof of seriousness.
Furthermore, focusing on keeping a “clean house” will also strengthen your hand in further negotiations because it will avoid any situation where a potential investor discovers a skeleton in the closet and asks subsequently for a discount. Or even worse, he discovers it after having entered your capital and sues you for misrepresentation at time of the transaction.
Tip 2: Define a clear common vision with your associates
What is the ambition of your company and how do you want to get there?
There are no good or bad answers to this question. It depends on the risk aversion of the entrepreneurs, on the development stage, on the competitive landscape and many more rational or psychologic factors. Then, it’s also a question of entrepreneur style. The paradigm is very well outlined by Noam Wasserman in his book “the founders dilemma”: you are either King or Rich. Either, the founder keeps control of the company and develops it with its profits which are progressively reinvested (bootstrapping). At the end of the day, he will keep a bigger portion of a smaller cake. Or, he raises external funding that will see him being diluted in the capital structure of a company which has more financial power in order to grow. He hence will have a smaller part of a bigger cake. That’s the reality. At TheClubDeal, we often have to remind this principle to start-up founders who do want to keep the power and at the same time, raise a lot of funding. They think they can handle it the same way as Mark Zuckerberg: but this is the exception which confirms the rule.
Tip 3: Prepare a well-articulated plan
Whatever the outcome of your above reasoning (grow with internal financial means or through external funding), you need a plan.
When Churchill famously said “Plans are of little importance, but planning is essential”, he highlighted that the essence of a plan is the reasoning behind it. This is especially true for a business plans. The purpose of the business plan is to display the planning capabilities of the team: how much thinking has been put into the plan? Is the plan credible? What are their assumptions? What are the critical variables that will make the company a success? What are the worst case and best case scenarios? You should demonstrate that you know your business model and metrics in depth.
Here again, the purpose is to build trust. The biggest risk an investor takes when investing in a company is the execution risk, the capacity of the executive team to deliver. A realistic and well thought plan is the best argument for mitigating this risk.
Where we disagree with Churchill’s quote when applying it to businesses, is that the plan – in itself - has an importance. You should not forget that, when contemplating a capital increase, you become the product. You are selling a business model, a plan, and the ability to deliver this plan broadly speaking. Investors know that there is a relative low probability that the business plan will materialize in the same fragrance than initially planned (common knowledge estimates between 70% and 90% of the investments do not deliver in line with their business plans). There are sometimes good reasons though: a strategy change due to the seizure of some additional opportunities, or new external factors like increased competition, …). However, failures to execute the business plan are way too often linked to bad reasons: poor execution, inappropriate people management, bad planning, wrong key assumptions, incomplete market understanding, wrong market timing, … Hence, investors will have a more than detailed look at it as the plan is the materialization of what they buy.
In more mature and developed business, the executives of the company (mainly the CEO) will defend their plan and the related financing requirements in front of the Board of Directors. The CFO will here play a central role in exploring all possible scenarios.
On a start-up level, the development path and required financing is often discussed informally between founders. In both situations, defining and sticking figures to the financial needs to implement the plan are important.
In addition, you should have a very articulated reasoning to support how much funding your business requires: working capital needs, additional investments required, … Defining the adequate capital is paramount: too much capital comes at a cost, too little jeopardizes the prospects of the venture.
What will funding enable you to do that you can’t do by yourself? This will depend on the sector and on the business model. What can external capital enable you to do faster? How do you create more value? Here, professional investors want to receive a crystal clear answer, based on observed metrics, that will illustrate the maturity of the project.
At TheClubDeal, we were sometimes surprised when constructively challenging entrepreneurs on what additional funding could enable: very early in the conversation, we saw cracks appearing in the entrepreneur’s storyline. At the contrary, very solidly built business plans are immediately considerably raising the level of trust and willingness to participate in the venture.
Tip 4: Do not overshoot your valuation
Established businesses with stable earnings are relatively easy to valuate: comparables, financial ratios and multiples are available across the board. The discussions are here focused on what should or should not be considered as part of the recurring revenue of the company (the adjusted EBITDA takes into account extraordinary items). However, when a company considers a capital increase, the main reason is that it seeks to develop the business even further and hence, it has to rely on a totally abstract component: the future value of that specific opportunity. Any elements which can provide an increased visibility are more than welcome: signed recurring contracts, … Discounted Cash Flows methods are useful tools but investors know they have some important flaws, the principal one is that it struggles to take into account the risks.
The difficulty is even more acute when trying to value start-ups which are in the “Death Valley”, the period between their seed funding and their potential Series A when there are signs of traction but no significant sales yet.
Here, we can only provide you one advice: do not overshoot!
We all know the negotiation game: valuations are rarely being negotiated upwards ;-)
A too high valuation puts you out of the market. Don’t forget that investors are very much solicited and you won’t have many opportunities to connect with them. They are proposed similar investment files on a frequent basis and “out of market” valuations will simply not give you the opportunity to present yourself and your company. In a capital increase process, the priority is to gather potential investors around the negotiation table.
In addition, a capital increase is also synonym of welcoming new skills, experience, networks and other intangible assets in the venture. Overshooting your valuation will most than probably scare off the type of investors you are focusing on: the smart money.
On a more pragmatic note, what are valuations? They are a theoretical number stuck to a company. The only real thing is the cash paid out by the investor and the issuing of new shares, all other things staying equal. Besides dividends and internal share transfers, it is only after a successful exit that shares transform in cash. One might say that, in early stages, distinguishing pre- and post-money is somewhat confusing. Indeed, the capital increase is generally the condition precedent for the money to materialize …
Furthermore, if you have followed the above advices (clean the house, define a clear vision, prepare a well-articulated plan), you should not fear to propose a reasonable valuation: you will have enough bargaining power to round up your capital increase by finding the right investors at the right price.
I hope you had an interesting read and invite you to subscribe to our newsletter and follow-us on Linked-In. Do not hesitate questioning or challenging any aspect of this blog issue. We love interacting and learning with others.
TheClubDeal is a private equity boutique which besides its own equity investment, invites targeted private equity investors to join them in carefully selected deals. We currently accompany and coach a dozen companies for capital increases and/or M&A.